BAFI 521 Final Assignment Crude Oil Price Project By: Harman Bajwa (Stu no: 80310089)

Crude Oil – A future from the past By: Harman Bajwa (80310089)
Crude Oil always been one of the most traded and desired commodities. Total crude oil
production was approx. 73 million barrels/ day in 2007. At inflation adjusted price average price
of $99 for 2008. It turns out to be worth of $2.7 trillion for entire year. That makes it virtually 6th
largest economy in terms of Purchasing Power Parity after US ($13.86 trillion), China ($7
trillion), Japan ($4 trillion), India ($2.9 trillion) and Germany ($2.8 trillion).

Introduction:

USA’s total energy consumption has increased from 31,981,503 Billion Btu in 1949 to
102,607,771 Btu in 2008. Out of this crude oil based energy sources increased from 1,448,158
billion Btu in 1949 to 35,558,967 in 2008. That is a whopping 34.65% in 2008 as compared to
4.5% in 1949. There are always talks of shifting to alternate energy options, but can any energy
substitute our such a high dependence on crude oil (petroleum universe)? Absolutely no, at least
in next 20-25 years. Crude oil was trading at average price of $3.32 in 1969 and in 2008 average
price was $99(Exhibit 1). That is 9% nominal increase in price and 4.9% in real terms (inflation
adjusted). This is phenomenal when we compare with one another highly traded commodity,
gold. Gold price was $129 in 1974 and it reached $889 in April, 09. This is increase of 5.84% in
nominal terms.

Purpose of the paper:

In this paper, I have tried to analyse the price movement of crude oil in respect to various factors.
Main questions which I will try to answer by the end of this paper are:-

 Is there any evidence that shows the correlation of crude oil price with respect to growth
in world GDP and if yes then how much? Can a person predict the crude oil price from
the expected GDP numbers?
 How is crude oil related to other major asset classes, S&P, US bonds and Gold?
 Is there any kind of relation between inventory or US dollar strength to crude oil?

Process followed:

I tried to check the dependence of all of these factors on each other and crude oil’s dependence
them. There were more then 20 different steps I followed and modelling techniques I tried. To be
honest, some of them were hit and trail, just to check, out of curiosity. But to my surprise hit and
trail really works. Before we go to analysis findings let me list few of the analysis i performed:

 Dependence of Crude Oil price on GDP growth was checked since 1969. For this first I
regressed crude oil price growth on world GDP. Then I divided the world into 14 parts on
basis of developed, emerging and under developed. This enabled me to check the
dependence on more minute level.

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BAFI 521 Final Assignment Crude Oil Price Project By: Harman Bajwa (Stu no: 80310089)

 Crude Oil price movement should be somewhere related to the inventory stock pile. As
supply and demand is well proven in terms of increase and decrease in inventory.
Because as per the strategic measure US government always strives to keep minimum
level of inventory. Thus crude oil was analysed in comparison to inventory.
 Purpose of this paper was from investment prospective, so it would not have been justice
to this paper id crude oil would not been tested in comparison to some other major assets.
After all its same liquidity that follows all the assets. For this various tests were
performed to analyse oil in comparison to S&P, gold, dollar strength, Bond yield,
inventory and CPI (consumer price index).

Now let us dig deeper and try to find the outcome of this exercise.

Three basic sections will be:

 GDP and Crude Oil.

 Inventory level and crude Oil.
 Other Assets, macro factors and crude Oil

GDP and Crude Oil:

Since 1969, world GDP since 1969 has grown from $15.029 trillion to $49,559 trillion. That is a
growth of 3.08% in real terms. This is comparable to the crude oil price growth of 4.9%.

When we regress crude oil on world GDP (Exhibit 2), the above mentioned point gets proved to
some extent. We get the equation Price = 0.0012x – 13 (Where x is GDP figure). This result had
t-stat of 5.82 and r2 of 47%. This implies that world GDP does explains the crude oil price
movement over longer term. However the GDP is unable to explain the short term crude oil price
volatility, which could be due to various other factors discussed later. Still some one can
question the 4.9% growth in crude oil price compared to 3.08% growth in world GDP. This may
be due to the greater share of crude oil in energy sources now, as compared to 4 decades ago.
Energy demand has grown at 2% since 1949, where as the crude oil usage has grown at rate of
5.63%. So the long term effect and price movement is very well explained by these 2 factors.
These factors hold true for coming 15-20 years as well as no drastic shift in energy sources is
expected, especially to substitute crude oil by a fair margin.

Now to dig deeper and find the influence of each of the major world regions on crude oil price, I
divided world into 14 parts in respect to their GDPs. North America, Latin America, South
America, Europe, Former Soviet Union, China, Japan, South Korea, South East Asia, South
Asia, Oceania, Middle East and Africa.

When I regressed the crude oil with on all these sub parts of world GDP over time, I was bit
disappointed. As collectively they were unable to yield any statistically significant result. T-stat
was poor so the regression equation was disregarded however r2 was healthy 90%. This proves a

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BAFI 521 Final Assignment Crude Oil Price Project By: Harman Bajwa (Stu no: 80310089)

point. In very long term, over 10 years crude follows the GDP and its usage but it is not
dependent on any single component when it comes to long term prospective.

North America being the dominant and largest trader of oil, was analysed separately. The results
showed the significance by t-stat being 5.34 and r2 being 42%. (Exhibit 3)

The movement of crude oil was traced in respect to the sub components. There was very
interesting findings(Exhibit 4). In recent years the crude oil price is highly correlated with
emerging markets, Correlation of 0.76 with China, 0.74 with South Asia (India being dominant
player in South Asia). Movement was least correlated with Japan and Europe at 0.56 and 0.66.
This establishes the shift of dependence of growth in crude oil in developing markets as
compared to developed markets.

Inventory Level and Crude oil:

We here it every day, “Crude rises due to fall in inventory” “Crude falls due to rise in inventory”.
How far these statements are true? US is the major inventory stock-holder for crude oil. It has
maintained the average gasoline inventory of 197,648 thousand barrels since 1986. Inventory
levels were at 215,636 thousand barrels in feb,2009. This explains the short term effect on crude
oil price. US started recording gasoline inventory in year 1945. The stock pile touched the
current average in the month of feb 1956 when the inventory was at 196,092 thousand barrels. In
May, 1984 the inventory stood at 252,634 thousand barrels. Lowest in past 25 years was in
Quarter 3 of 1995 at 190,884 thousand barrels. There was increase in price of oil by around 25%
in forth coming quarter, which was not much in absolute terms.

Now to validate these points, I regressed the crude oil price on inventory. To further extract facts
I analysed the crude oil price in comparison to inventory data over each of preceding 12 months.

The regression results over time was insignificant and did not proved that ideally crude tracks the
inventory over longer period of time. However there were some noticeable findings in
correlation test. The price of crude oil was negatively correlated with inventory, let it be of any
month. The correlation (Exhibit 5) was in the range of -0.15 to -0.25 from same month to past 12
month inventory data. This shows that over shorter term, inventory data does affect the crude oil
market. This could explained as a reason of US governments strategic decision of maintaining
minimum level of gasoline stock any given time. So if inventory falls, the government is
expected to buy more of oil stock to fulfill the strategic numbers and this is done over the period
of 3-12 months.

Other Assets, macro factors and crude Oil:

Crude oil is among the most important commodity and is considered as an asset by lot of Asset
managers. So it is advisable to compare the movement of crude oil in comparison to other
prominent asset classes in the markets. The asset classes chosen for the comparison are S&P

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BAFI 521 Final Assignment Crude Oil Price Project By: Harman Bajwa (Stu no: 80310089)

(representing equity), Moody’s AAA rated bonds (debt) and gold (bullion). Forex being the most
traded market, cannot be ignored. So the dollar index (Index presenting the strength of dollar in
comparison to basket of world currencies) was also included. People spend money and their
buying power need not to be ignored. To capture the time value, CPI was also included in the
analysis.

First crude oil’s dependence was tested on all of these 5 factors. Rationale behind this was, the
money flow from one asset to other. However the results were significant only for Consumer
Price Index and Yield of bond (Exhibit 6). T-stat being 6.6 and 2.5 respectively. Other factors
were ignored and again regression analysis was done to check the dependence on these 2 factors.
Results were further significant and brought in the equation of 7x 1+ 0.27x2 – 0.01 = Price.
Standard error of 6%. This again proves the fact that over longer run the crude oil price does
depicts the economy. The measure could be through any gate and here the gate is Consumer
Price Index.

Now to check the correlation (Exhibit 7), we found that price of oil is inversely correlated to
Dollar strength and S&P, where as it is directly correlated to CPI, bonds and gold. Interestingly
this also shows the CPI’s direct correlation with Bond, Dollar strength and gold and inverse
correlation with equity. Graphs further shows this visibly. (Exhibit 8)

This explains a very important aspect of investment finance, the money flow. When equities are
out of favour, investors rush into fixed returns and commodities to some extent.

Conclusion:

Price Movement of Crude Oil over shorter term: It is very difficult to estimate the price
movement of the crude oil over very short term. However if any estimates are to be made, the
closest indicator can be the preceding inventory data.

Price Movement of Crude Oil over medium term: Over medium term we can get a rough
estimate based on the yields, performance of other asset classes. This is due to the movement of
money flow across assets. Inflation prediction is also good way as Crude is one of the important
factor in inflation index.

Price Movement of Crude Oil over long term: This is the safest bet. Over long term horizon,
over a period of more than 10 years, crude oil does follow the growth in world GDP and
resulting energy demand. To be more precise, it follows the crude oil dependence out of the total
energy demand. Thus, proving the old war house of supply and demand true over a longer
period. In shorter term, the one off events do create euphoria or panic thus bringing in strong
price movements, which could be termed as irrational exuberance and can be left to be analysed
and debated further.

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BAFI 521 Final Assignment Crude Oil Price Project By: Harman Bajwa (Stu no: 80310089)

Appendix:

Exhibit 1: Crude Oil Price

$120.00

$100.00

$80.00

$60.00
Nominal
Real
$40.00

$20.00

$0.00

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BAFI 521 Final Assignment Crude Oil Price Project By: Harman Bajwa (Stu no: 80310089)

Exhibit 2:

SUMMARY
OUTPUT

Regression Statistics
Multiple R 0.6865942
R Square 0.4714117
Adjusted R Square 0.4575014
Standard Error 13.57484
Observations 40

ANOVA
df SS MS F
Regression 1 6245.047695 6245.047695 33.88959207
Residual 38 7002.498345 184.2762722
Total 39 13247.54604

Standard
Coefficients Error t Stat P-value
-
Intercept -13.897123 6.825725166 2.035992138 0.048765784
World GDP 0.0012801 0.000219892 5.821476795 1.00062E-06

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BAFI 521 Final Assignment Crude Oil Price Project By: Harman Bajwa (Stu no: 80310089)

Exhibit 3:- Crude Oil to North America GDP.

Regression Statistics
Multiple R 0.654862
R Square 0.428845
Adjusted R
Square 0.413814
Standard Error 14.11084
Observations 40

ANOVA
df SS MS F
Regression 1 5681.142 5681.142 28.53184
Residual 38 7566.404 199.1159
Total 39 13247.55

Standard
Coefficients Error t Stat P-value
Intercept -11.0033 6.891096 -1.59674 0.118608
N.A GDP 0.00395 0.00074 5.34152 4.55E-06

Exhibit 4:- Correlation of Crude Oil with World and sub- section GDPs.

OIL Prices
Oil Prices 1
World GDP 0.686594248
N.A GDP 0.654862499
Latin America 0.722139321
South America 0.724725395
Europe 0.666769808
Former Soviet
Union 0.616725507
China 0.761526731
Japan 0.567782092
South Korea 0.658825989
Southeast Asia 0.686883247
South Asia 0.745658583
Oceania 0.678361263
Middle East 0.722979471
Africa 0.787066481

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BAFI 521 Final Assignment Crude Oil Price Project By: Harman Bajwa (Stu no: 80310089)

Exhibit 5a:- Correlation with Preceding Inventory:

Inv-1 is inventory in previous month and so on till Inv-12 which is Inventory in month, year
back.

Price
Price 1
Inventory -0.216835456
Inv-1 -0.199978153
Inv-2 -0.173857072
Inv-3 -0.155361548
Inv-4 -0.148656704
Inv-5 -0.152034233
Inv-6 -0.157660598
Inv-7 -0.176082648
Inv-8 -0.200115604
Inv-9 -0.222534531
Inv-10 -0.239238949
Inv-11 -0.248641244
Inv-12 -0.245368305

Exhibit 5b:-

Inventory Graph:- We have done Inventory – 189,000 thousand barrels so as to clearly show the
inventory on comparative basis.

Inventory-189000
70000
60000
50000
40000
30000
20000 Inventory-189000
10000
0
-10000
Mar-1987

Mar-1994

Mar-2001

Mar-2008
Jan-1986

Jan-1993

Jan-2000

Jan-2007
May-1988

May-1995

May-2002
Nov-1991

Nov-1998

Nov-2005
Jul-1989
Sep-1990

Jul-1996
Sep-1997

Jul-2003
Sep-2004

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BAFI 521 Final Assignment Crude Oil Price Project By: Harman Bajwa (Stu no: 80310089)

Exhibit 6: Oil Dependency on CPI and Bond Yield.

SUMMARY
OUTPUT

Regression Statistics
Multiple R 0.372421
R Square 0.138697
Adjusted R Square 0.134516
Standard Error 0.06822
Observations 415

ANOVA
df SS MS F
Regression 2 0.308769 0.154385 33.17258
Residual 412 1.91744 0.004654
Total 414 2.226209

Standard
Coefficients Error t Stat P-value
Intercept -0.01655 0.005002 -3.30918 0.001018
cpi returns 6.959657 0.989426 7.034033 8.41E-12
yield chamge 0.270945 0.127639 2.122748 0.034371

Exhibit 7:

Correlation to Different Asset classes and factors:

OIL
returns
OIL
returns 1
cpi returns 0.104459
yield
chamge 0.10595
dol ret -0.03372
gold ret 0.077895
s&p ret -0.07767
int change -0.08131

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BAFI 521 Final Assignment Crude Oil Price Project By: Harman Bajwa (Stu no: 80310089)

Exhibit 8: The return of different Indexes. The vertical scale is logarithmic scale so that an
efficient comparison can be made of different priced indexes with different base years.

10000

1000

Oil Price
100 CPI
Dollar index
Gold
S&P
10

1
Aug-75

May-80

Aug-83

May-88

Aug-91

May-96

Aug-99

May-04

Aug-07
Mar-77

Jan-90
Jan-74

Oct-78

Jan-82

Mar-85
Oct-86

Mar-93
Oct-94

Jan-98

Mar-01
Oct-02

Jan-06

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